The "Magnificent Seven" stocks achieved an average return of 335% during the last five years, while the S&P 500 (^GSPC -0.29%) advanced 92%. That dramatic outperformance has led to those companies becoming a large part of the overall index. The Magnificent Seven account for one-third of the S&P 500 by market value.
Lisa Shalett, chief investment officer at Morgan Stanley, sees that concentration as a substantial risk. Not just because seven companies represent a large percentage of the entire U.S. stock market but also because they trade at expensive valuations.
Indeed, Shalett says the Magnificent Seven are currently as expensive relative to the other 493 companies in the S&P 500 as the biggest stocks were at the peak of the dot-com bubble. "That sort of concentration in the S&P 500 can lead to greater volatility and the potential for significant drawdowns."
Meanwhile, the S&P 500 itself also trades at a historically expensive valuation, making the current situation even more fraught. Here's what investors should know.
Image source: Getty Images.
The S&P 500 trades at a high valuation that has historically preceded negative returns over the next 3 years
The S&P 500 is widely considered the best benchmark for the entire U.S. stock market. The index is frequently valued by its price-to-earnings (PE) ratio, which compares its current market value to the aggregate earnings of every member company. But that strategy fails to account for inflation and natural fluctuations in earnings that occur throughout the business cycle.
Robert Shiller, an economics professor at Yale University and Nobel laureate, addressed the issues by creating the cyclically adjusted price-to-earnings (CAPE) ratio. That metric compares the S&P 500's market value to the average, inflation-adjusted earnings from the past 10 years.
The S&P 500 recorded a CAPE ratio of 37.8 at the end of July, a significant premium to the historical average of 21.2. In fact, the index's monthly CAPE ratio has exceeded 37 on only 39 occasions since it was created in 1957, which means the valuation today is higher than 95% of historical values. In other words, the S&P 500 has been this expensive only 5% of the time since its inception nearly seven decades ago.
Unfortunately, the S&P 500 has typically performed poorly under such circumstances. The chart below shows the index's average return over different periods after its monthly CAPE ratio topped 37.
|
Holding Period |
S&P 500 Return When CAPE Ratio Exceeds 37 |
|---|---|
|
1 year |
(3%) |
|
2 years |
(12%) |
|
3 years |
(14%) |
Chart by Author. Data source: Robert Shiller. CAPE Ratio = cyclically adjusted price-to-earnings ratio.
As shown above, after recording a monthly CAPE ratio above 37, the S&P 500 has generally declined over the next one, two, and three years. In other words, historical data suggests the benchmark index will decrease 3% by July 2026, 12% by July 2027, and 14% by July 2028.
Prudent decision-making and patience are key to turning a profit in the stock market
To summarize, the S&P 500 currently trades at a historically expensive valuation, and the present valuation gap between the Magnificent Seven and the other 493 stocks in the index is similar to the valuation gap between the largest technology stocks and its other constituents during the dot-com bubble.
Investors must make prudent decisions in the current environment to avoid huge losses. That means not only avoiding stocks that trade at unreasonable valuations but also those you would feel uncomfortable holding during a severe market downturn. Also, now is a good time to build an above-average cash position. Having capital ready makes it possible to quickly capitalize on drawdowns.
Last but not least, investors must remember the U.S. stock market has created wealth like clockwork over long periods. Even money invested in the S&P 500 at the height of the dot-com bubble in December 1999 -- when the index had a CAPE ratio above 44 -- would have compounded at 8.1% annually over the last 25 years, including dividends. In short, patience is often critical to making money in the stock market.
